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Summary:

On Friday, Facebook announced a five-to-one stock split, a mere formality intended to help bring its share price back down into the range of its peers. So why did much of the media coverage make it sound like it was magically pumping up Facebook’s valuation?

Facebook trades on Sharespost

What is it about a stock split that sets off speculation? It is one of the most mundane and technical developments in the stock market, with little or no impact on a company’s fundamental performance, and yet news of a split can set a stock’s valuation soaring.

It’s a common enough phenomenon in the public markets and, as Facebook shows, it can happen to privately held companies too. On Friday, Facebook said each of its shares would split into five shares, worth one-fifth of its former value. It was a mere formality intended to help bring Facebook’s share price back down into the range of its peers, a move helpful in granting stock units to newer employees.

Hint: More shares don’t make a higher value

This is pretty boring stuff. And yet much of the coverage of the split made it sound like it was magically pumping up Facebook’s valuation. Some sites, which only a week ago estimated the company to be worth $25 billion, now said it was worth $32 billion. That would mark a 28 percent surge in one week, with little news besides the stock split (and David Fincher’s unflattering movie, which certainly couldn’t have helped).

Adding to the speculation about Facebook’s value was Peter Thiel, a board member who said the company was worth $30 billion. Even the Financial Times pegged the startup’s value at $34 billion, based on the prices paid on Sharespost, an online secondary-market for stocks of privately held companies.

I defer to Thiel’s knowledge of Facebook’s financial details. But I also respect common sense, which tells me that a company making $1 billion in revenue this year can in no rational way be valued at $30 billion right now. And besides, valuing a private company is more art than science, a process of building consensus among insiders, outside investors and supposedly independent appraisers. Consider that Google’s underwriters initially valued its 2004 IPO as high as $37 billion. Google debuted a few months later worth $23 billion.

Trading volume is too low to make an accurate valuation

While I also think sites like Sharespost offer a potentially valuable service by facilitating trading of privately held stock, there is a big risk in using their data to value a company. Most of the recent trades of Facebook shares that have been completed have been between $70 and $76 a share, a range that implies a value for the company between $31 billion and $34 billion a share.

But look closely, and you’ll see there have only been ten trades in Facebook’s stock so far this year. Companies can be hard to value in illiquid markets, and one trade a month is more than illiquid — it’s a drought. In such a market, two Facebook shareholders could sell 500 shares back and forth to each other and invent whatever valuation they desired. And nobody would be the wiser.

A legal loophole could create pent-up demand for an IPO

In fact, Facebook shares have been so scarce on the secondary market that there must be a substantial premium to pay simply for the right to own them. This is by design. Back in 2004, Google was pressured to go public against its wishes, in part because of a securities law that required companies with more than 500 shareholders to disclose financial data. Today, Facebook has 1,700 employees. Most of them must hold some equity in the company. But Facebook doesn’t plan to go public for another two years.

Why? Facebook created a loophole in the securities law. It handed out restricted stock units to employees that could never be sold to another person until Facebook was acquired or until six months after an IPO. Then it won the SEC’s permission to delay an IPO as long as those stock restrictions remained in place. Presumably, the few shares you could buy on a secondary market like Sharespost were issued before the restrictions went into place.

This was a cunning move, allowing Facebook to keep private and disclose only the information it wishes to. But one day it could come back to haunt the company. Eventually, employees will demand an IPO so they can cash in on their long-held shares. Then six months after the IPO, when insiders can freely sell shares on the public market, the pent-up demand will be unleashed, driving down the stock price with the sudden supply.

And if that happens, Facebook’s market value could be worth considerably less than $30 billion.

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  1. Fascinating article, and indeed it could come back to haunt them, but i suppose this will be a long time in the future, and by then will any of those members who organised this split be there? Its a short-term gain but then maybe that’s not a bad idea as someone could always come along in the future and burst the Facebook bubble.

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  2. Stock splits have historically been a good sign when they are done on Wall Street. Reverse splits on the other hand, have historically been bad signs. Not always true, but they are good patterns to follow. I have bought stocks several times after hearing they are announcing a stock split and I have always got lucky with them and made money.

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  3. Kevin,
    I would agree with you here! How come some punters are valuing FB @30 billion, when the annual turnover is 1 USD billion?
    I think it is just too much hype on FB, an IPO would certainly drive the share price down, much lower than anyone expected!

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  4. Splitting a company stock usually results in some additional increase in valuation but I agree with the author of this article in that the value of a private share in a none publicly trading company is not easily determinable. Only in a freely trading market can a share’s price be effectively determined as the price of any share is only what others are willing to pay for it.

    Clay Perreault

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    1. Most big boards are crooked .

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  5. Two problems with this article:

    Valuation: Facebook could certainly be worth more than $30 billion based on it’s growth rate. What we see happening with Facebook usage and growth is without parallel. Facebook at this point is clearly headed for google sized valuation.

    As for employees “demanding an ipo” – this is just silly. There is only one employee that can demand an ipo and we know who that is. The pressure for employees to turn shares into cash was recently blunted by the employee share sales to digital sky technologies. No doubt they will turn to this type of transaction again if needed.

    Facebook has it figured out. Very impressive.

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  6. There is a lot to read in the stock split. Many companies prior to an IPO do a stock split to build liquidity in an imminent IPO and part of rationalization of the stock price upon going public. It’s becoming more apparent that this could imminent, my bet is that it would be within the next year.

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